Valuing Starbucks with Economic Profit Models

June 23, 2017

[edit]: My original economic profit model had an error. It was overestimating future invested capital. I kept the original images of each economic profit model but added updated values below them. This also changes my conclusion about Starbucks being overvalued or not.

If you only looked at the P/E ratio Starbucks (SBUX) looks expensive with a current P/E of 29. I want to look at it a different way. I want to look at Starbucks’ value through discounted economic profit models.

The discounted economic profit model allows us to move away from multiple based valuations and value companies based on the returns they generate on their invested capital.

In this exercise, I only want to play around with one variable, ROIC. Yes, I use two different discount rates but I do this to look at a range of estimated prices.

In each model, I will keep Starbucks’ expected growth rate over the next 10 years and its continuing value the same. Again, playing with one variable.

Starbucks Growth Estimates

The common expectation for Starbucks is it will grow 9-10% per year over the next 5+ years. I used this growth rate in each model.

I create models with lower growth estimates too. I want to look at a range of price estimates given different assumptions. I also do not want to make this post extremely long so I will use 9% as my growth rate assumption and just play around with different ROIC scenarios.

Starbucks WACC

Given the low-interest rate environment, I calculated Starbucks’ WACC to be around 6.62%.

When I adjusted current interest rates to a more “normal” environment, 4% on the U.S. 10 Year, then Starbuck’s WACC increased to 8.2%.

In the following models, I used the 6.62%. Maybe the U.S. 10 Year creeps back up to 4% but the issue is when will this happen?

What I wanted to do in this exercise is value Starbucks in the world we live in now.

Continuing Value

A big part of Starbucks present value comes from my estimate of its continuing value. My economic profit model projects the next 10 years for ROIC, Invested Capital, WACC, and NOPAT (Net Operating Profit After Tax).

For Starbuck’s continuing value, I had to come up with values for ROIC, NOPAT, the growth of NOPAT, WACC, Return on Newly Invested Capital for year 11 and beyond.

For continuing ROIC I used 15%. This is the average ROIC for food, beverage, and tobacco companies as calculated by McKinsey.

For NOPAT I used Starbucks’ 10-year average NOPAT margin to get these values.

For NOPAT Growth I assumed a 2% growth rate. I kept it in line with estimates for long-term U.S. GDP growth.

For WACC I used the average WACC for the Food and Beverage Industry. I estimated this average to be around 8.84%.

Return on Newly Invested Capital (RONIC). I brought this down to equal WACC. This is what would happen in a highly competitive industry. It is easy to argue that Starbucks’ brand and leading market position will allow it to earn higher returns on newly invested capital. I kept my expectations low.

Average ROIC

Over the last 10-years, Starbucks averaged a ROIC of 21.66%. In this model, Starbucks continues to earn 21.66% over the next 10-years. Then I discounted the economic profit created at Starbucks’ WACC, 6.67%, and then by 10%.

WACC Discount Rate

WACC Discount Rate & 10 yr average ROIC. Click image to enlarge.

This model produced a per share equity value of $46.50.

[Edit] The updated model produces a per share value of $32.46.

10% Discount Rate

10% Discount Rate & 10yr Average ROIC. Click image to enlarge.

This model produced a per share equity value of $43.69.

[Edit] The updated model produces a per share value of $30.78.

High ROIC

What if Starbucks maintains its current ROIC of 31.91% over the next 10 years?

It’s possible.

Starbucks is a big well-known brand with loyal customers. It’s app, rewards program, branded food sales, prime locations, and international growth can all certainly help Starbucks maintain a high future ROIC.

WACC Discount Rate

WACC discount rate & current ROIC. Click image to enlarge.

This economic profit model produced a per share equity value for Starbucks of $58.45.

[Edit] The updated model produces a per share value of $39.66.

10% Discount Rate

10% discount rate & high ROIC. Click image to enlarge.

In this economic profit model, Starbuck’s per share equity value is $53.72.

[Edit] The updated model produce a per share value of $36.84.

Fading ROIC

It is easy to argue that Starbucks has a large business moat that will allow it to continue to earn high returns on invested capital for many years into the future.

But Starbucks can lose its high ROIC. It operates in a highly competitive industry. Starbucks’ ROIC could fade towards the industry average as competitors take business away from Starbucks.

This economic profit model starts with Starbucks’ current ROIC and faded it to the Food & Beverage industry average of 15%.

WACC Discount Rate

WACC discount rate & fading ROIC.

This produced an equity per share value of $47.15 for Starbucks.

[Edit] The updated model produces a per share value of $32.92.

10% Discount Rate

10% discount rate & fading ROIC. Click image to enlarge.

This economic profit model produces a per share equity value of $44.66.

[Eit] The updated model produces a per share value of $31.42.

Industry Average ROIC

In this model let’s assume Starbucks loses its dominant market position and its ROIC immediately falls to the food and beverage industry average of 15%.

Why would we keep the growth rate at 9% if Starbucks experienced an immediate reversal like this? For simplicity sake. I just want to play with one variable, ROIC, in this exercise.

WACC Discount Rate

WACC discount rate & industry average ROIC. Click image to enlarge.

Starbucks has a per share equity value of $38.74 in this economic profit model.

[Edit] The updated model produces a per share value of $27.79.

10% Discount Rate

10% discount rate & industry average ROIC. Click image to enlarge.

Starbucks has a price per share of $37.17 in this model.

[Edit] The updated model produces a per share value of $26.85.

Which is Correct?

The industry average ROIC model is worth looking at. Is it highly likely to happen over the next 5-10 years? I don’t think so.

The fading ROIC is helpful if I made a mistake about Starbucks’ business moat. How much am I overpaying if Starbucks is not as dominant as I thought and Starbucks mean reverts towards being an average business? Based on these models, I wouldn’t be overpaying by too much.

The two models that should garner the most weight are the 10-year average model and the continuing high ROIC model.

I think Starbucks does have a large business moat that will allow it to generate high returns on capital going forward.

Starbucks currently trades around $60 per share. This looks like a fair price for Starbucks based solely on the economic profit models used in this post. Maybe a few dollars over the exact estimates of fair value but models are not an exact science.

Contrary to Starbucks P/E ratio and based solely on these economic profit models Starbucks does not appear overvalued.

[Edit]: The 10-year average ROIC and the High ROIC model are still the most applicable valuation models. But now instead of being reasonably priced the models are saying that SBUX is overvalued. Using ROIC, WACC, and Growth rate, and the Gordon Growth Model, I come up with a levered P/E ratio of 22. Applying this multiple to Starbucks’ earnings produces a per share price of $44.

Using ROIC, WACC, expected growth rate, and the Gordon Growth Model, I come up with a levered P/E ratio of 22. Applying this multiple to Starbucks’ earnings produces a per share price of $44. In line with what the updated economic profit models are saying.